Money madness: Can Wall St be fixed?

There's a whole lotta bull on Wall Street. Image by Marionzetta via Flickr

The largest New York-based Wall Street firms lost $35 billion in 2008. And they handed out $18.4 billion in bonuses.

That’s the sixth-largest amount of year-end rewards Wall Street has handed out, according to the New York State comptroller’s office. And that was a decline from $32.9 billion in bonuses in 2007, when the New York firms lost about $12 billion. That’s not sane.

And yet preserving the bonus structure is the most pressing issue on the minds of Wall Street executives, to judge by the opposition to plans to reform and regulate the compensation structure of banks.  It’s why AIG guaranteed 2007-level bonuses for 2008 and 2009 (as I pointed out) and why there is a drumbeat of doomsayers saying the best minds of Wall Street will flee, insulted by the prospect of foregoing multi-million dollar year end payouts. The beat goes on in today’s Wall Street Journal report on plans in the Obama administration.

Bank executives have complained to federal officials that strict rules could prompt some of their best employees to move to … hedge funds, private-equity firms and foreign banks. They’ve also argued that paying substantial bonuses is integral to how the industry works.

Sure, bonuses are a part of the business, but paying record-testing bonuses isn’t. I get that Ken Lewis and Vikrim Pandit and Edward Liddy don’t want the halcyon days to end. But they’re over. Let’s take a quick look at where the best of Wall Street will flee:

Hedge funds: no doubt, hedge funds have been growing at an astonishing rate – the number of new funds formed has been rising at a 20% annual rate for the past decade by some reports. Lots of jobs to be had there. But this also means the complex and minute market discrepancies a hedge fund manager exploits are all being pursued by hundreds of others now. No wonder hedge fund performance stinks. The average hedge fund lost 16% in 2008 – and since hedge funds don’t have to report performance to the public, that’s only the average of the self-reported hedge funds. All the mega-losers simply aren’t disclosing it. My investing newsletter (the Cabot Green Investor) beat that average last year, and I don’t charge you 2% of assets and 20% of profits like the Greenwich crowd. When you stink at making money and you charge the ridiculous 2 and 20 (or 3 and 25, as some do), you go out of business fast. Some industry estimates see the number of hedge fund falling in half from mid-2007 levels by the end of this year.

Private-equity. All that cheap credit and low interest rates we enjoyed the past 10 years to buy cars, fund vacations and flip houses? Private equity enjoyed it too – it’s why they made silly purchases like Cerberus buying Chrysler for $7.4 billion in mid-2007 or TPG Capital pumping $1.5 billion into Washington Mutual just five months before that bank fell apart. Credit markets are necessarily less free and easy with Benjamins now. You can’t flip houses anymore, and private equity can’t flip companies either. This simply is not a growth area for disenfranchised investment bankers. Especially if you believe the cost of capital is going to increase further, which I do.

Foreign banks. You must be joking. In Switzerland the government has just capped annual banker compensation to the $400,000 range. Will they go to Canada, Spain, Brazil or China? All of these countries came through the banking crisis relatively unscathed in part because they never let bank compensation get out of whack by letting it be based on short term risky bets like the US and UK did. Ireland, Britain, France, Australia? The party’s over in those countries, too. That’s basically what last month’s G-20 conference was addressing.

I guess they could go into journalism, but editors mainly fall in thrall to fraudulent equity analysts, like Henry Blodget, not investment bankers. The pay stinks anyway. (Oh wait, Blodget didn’t admit guilt. He simply paid out $4 million to settle the matter. My mistake.)

So, now that we’ve determined they really don’t have anywhere to go, how do we reform Wall Street’s compensation? I’ve discussed this at length with a number of industry people in recent months, and so here is what I suspect the government is considering:

1. Group incentives, not individual ones. Like it or not, bankers do need to make good money, otherwise they won’t put up with long nights and stressful days. But rather than incentivize one person, banks should incentivize departments and overall production. There was a (probably false) story circulating the Street the past couple of years of a bond salesman who goes to visit the corporate treasurer of a Fortune 500 company. When he offers his business card, the treasurer says “Just throw it in there,” while pointing to a fishbowl filled with cards. Seeing the banker’s reaction, the Treasurer adds “Don’t be offended, they’re all from your firm.” This illustrates how there is no concept of corporate customer service, it’s just everyone for his or herself looking to not only beat the other banks, but his or her colleagues too. Link some of the annual compensation to overall department performance or client-generated business. Other industries do this quite successfully.

2. Don’t base rewards on paper gains. On Wall Street, they’ve been paying bankers for chickens before they have hatched. The reason there have been so many large bonuses while Wall Street paints itself red? Bonuses have been paid out based on the year-end paper gains of CDOs and swaps and other complex, illiquid instruments, not after the trades of those instruments have closed. That means in 2006, when one trader’s book of CDOs looked magnificent, he got a huge bonus. No matter the company probably lost many millions on the same trades when they were closed out last year while the trader was enjoying the South Fork social scene. Make it so a closed trade that generated an actual profit pays out 100% of the bonus allotment, but that paper gains only pay 50%, with the other half to come when the trade closes, no matter how far down the line that is. Also, make some of the bonuses payable in restricted stock, not cash, so the bankers have vested interest in ensuring the company’s health. That was one good idea Lehman actually was implementing before it failed.

3. Pay risk-weighted bonuses. A big problem with the risk Wall Street finds itself taking on regularly is that traders are playing with house money. It’s not their skin in the game. Yet internally, banks tend to treat all trading desks equally: someone trading Treasury bonds – a stable, very liquid market – faces the same compensation evaluation as a trader leveraging CDOs – a very volatile, illiquid market. Banks should adjust bonuses based on the risk traders and departments put on their capital. Essentially, give the bonus a risk “haircut.” A closed-out trade that generated a profit would be calculated as eligible for 100% of the bonus level. An outstanding trade would be discounted, say by half, because it is still open, then get another haircut based on the riskiness of it. Less for outstanding Treasury or straight equity trades, a larger one for swaps, derivatives or anything else not frequently traded.

That’s a start. Will it happen? It better, or else we’ll be discussing another burst bubble next decade.